12 things everyone should know before investing in stocks

Keep these 12 things in mind if you're planning to invest. Getty Images / Kiyoshi Ota A few days ago, our family was driving to a school event together.

We were listening to a podcast over the car's stereo and the host was talking about how they were worried about the stock market being so high.

My children are naturally curious creatures and so they wanted to know why this host was so worried, and this led into a long discussion about investing in stocks as opposed to investing in other things.

They wanted to know what stocks were, why someone would buy them, and how someone would do this (you don't just go to a store to buy them).

After we arrived at our destination, I realized that the conversation we had would actually make for a pretty good article, one that I would have found incredibly valuable a few years ago when we were first learning about investing.

Here are a dozen key things everyone should know about investing in stocks.

1. Investing in stocks is one of many options for investing your money.

It's pretty hard to avoid hearing about the stock market in one way or another. News about the stock market shows up on practically every news report you hear on the radio or on television. However, just because the newspaper and the financial media talk nonstop about stock investing doesn't mean it's the only way to invest your money. It's merely one option.

One could simply keep their money in a savings account, earning a low return with very low risk. One could invest in real estate or bonds or collectibles or precious metals or foreign currency. All of these things have some level of risk involved, offer some level of return, and have varying degrees of liquidity (liquidity essentially means how easy it is to sell an item once you own it). You can even invest in yourself, improving your future earnings potential.

Don't ever buy into the idea that stocks are what you must invest in. They're just one option that happens to change enough all the time that it generates news. Many other investments are more stable and quiet, meaning they aren't talked about nearly as much.

If you follow the news, you'll see the risk in stocks. Getty Images / Mario Tama

2. Investing in stocks comes with substantial risk, especially in the short term.

If you listen to the news every day, you'll undoubtedly hear about various numbers like the S&P 500 and the Dow Jones Industrial Average going up and down some amount. Maybe it went up 1% today or down 0.5% yesterday.

That's a lot of up and down movement. You can easily gain — or lose — as much in a single day on your investment as you would gain in an entire year if that money were in something stable and secure like a savings account.

Another problem is that you can have periods where there are far more down days than there are up days. The latter part of 2008 is a period where that occurred and the stock market dropped about 40% that year (depending on how you measure it). If you had $10,000 in the stock market at the start of 2008, it was worth about $6,000 at the end.

So, why would you ever invest in stocks? Over the long haul — more than a decade — the stock market tends to grow at a rate of about 7% per year. It takes a lot of years to approach that average, though. Sometimes, it'll be higher; sometimes, it'll be lower.

It's not a guarantee, though. That's just what has happened historically and, in the future, that trend should continue as long as people keep being more productive and generating good ideas. If you want a guaranteed return on your money, you won't get an annual return anything like that unless the economy drastically changes.

The stock market makes a lot of sense over the long term. It doesn't make much sense for individuals who aren't paying a lot of attention in the short term. I'd say that the difference is somewhere around the ten year mark.

3. Most people invest in stocks by opening an account with a brokerage — today, that's usually done online at the brokerage's website.

How exactly do you buy stocks? Most of the time, people do this by opening an account with a brokerage firm. A brokerage firm is a company that has access to the stock exchange, so they'll take instructions from you, go to the stock exchange, and actually buy or sell stocks according to your instructions.

When you open an account with a brokerage, you usually deposit some money with them by transferring it from your checking or savings account. Once the money's there, you can then ask the brokerage to buy a certain amount of whatever stock you want. For example, you might want to buy $100 worth of Coca-Cola stock. You can submit more complex requests, too; for example, you might have an order to buy 50 shares of Coca-Cola stock when it dips below $40 per share. Typically, the brokerage charges a fee for doing this.

Later, you might choose to buy more shares — meaning you'd submit another buy order — or you might choose to sell your shares. In either case, the brokerage will charge you a small fee for each transaction. That's how they make their money. After you sell your stock, you can just transfer the money back to your savings account.

Fees vary between brokerages. Margin Call

4. Different brokerages have different strengths and weaknesses.

Naturally, different brokerages have very different strengths and weaknesses. Some have very high fees on transactions but will offer a ton of help to individual investors. Others might offer lower fees but be very hands-off. Some might charge nothing for certain types of transactions (usually when you're buying the company's own investments, which I'll explain below).

What brokerage do I use? I use Vanguard. This is mostly because I invest my own money in Vanguard funds (which I'll explain below), for which they don't charge any transaction fees. You can read about Vanguard's brokerage services here if you're interested.

Anyone who invested in the Google IPO made a lot of money over the past decade. Adam Berry / Getty

5. Investing all of your money in the stock of a single corporation is very risky: You can quickly lose most (or all) of your money, but it also has the potential for huge returns.

There are countless stories out there about investors getting in on the "ground floor" of a company that went onto great things. For example, if someone was able to buy in during the Google IPO has made a lot of money over the last decade.

That being said, there are a ton of risks here. Quite often, those huge success stories exclude the fact that the investor made a lot of investments that completely failed before that big success happened. If you make 10 investments and they're all mediocre — not earning any returns at all — and then make one more that earns a big return, your overall return is not that big.

While stocks can sometimes skyrocket, companies can often completely fail as well, which causes their stock to become worthless. In fact, entire industrial sectors can fall into nothingness over time — remember, typewriter companies were probably good investments several decades ago. Of course, you can invest in a big company to drastically reduce the chance of failure, but that also drastically reduces the chance of big success, too. Coca-Cola is as steady as a rock, but it's not likely to quickly double your money, either.

6. A good strategy for reducing risk is to spread out your investments across the stocks of lots of companies, but that has complications, too.

One common strategy that people suggest to reduce risk when investing in stocks is to invest in a lot of different companies at once. If you buy stock in 20 different companies in twenty different markets, you're going to reduce your risk of losing all of your money — after all, 20 companies simultaneously failing is a pretty unlikely event. But you're also reducing your ability to earn big returns — after all, 20 companies simultaneously skyrocketing is an unlikely event, too.

The real drawback here is that if you invest in 20 stocks, you're going to have to execute 20 "buy" orders with your brokerage, as was discussed above. If each one costs you $10, that's $200 in fees. If you then need to sell all of those stocks, you're going to have to execute twenty "sell" orders. That's going to add up to another $200 in fees. If you have $10,000 to invest, that's $400 in fees that vanishes right off the bat — you're only going to actually get to invest $9,800 of it (after paying the $200 in buy fees) and then they'll scrape off $200 in returns when you sell it, too.

In other words, even if you invest in an above average stock, the fees will knock that investment down to average pretty quickly. You can reduce the impact of those fees by investing large amounts in a single stock, but in order to that, you either have to be carrying a lot of risk (as your chances of losing a lot of your investment is much higher if you own just one stock) or have a lot of money (so that you can invest sizable amounts in a lot of different stocks), reducing the percentage impact of the fees.

Dividends give you a stream of income to use. Joe Raedle/Getty Images

7. Most stocks pay you dividends, which provides a stream of income for you without having to sell the shares.

While investors are very interested in the rise and fall of the value of stocks, they're also very interested in the dividends that many stocks pay.

Dividends are small payments that companies pay out to each stockholder, usually a small amount. For each share of stock that you own in that company, the company will pay you some small amount — usually less than a dollar — on a regular basis, typically every quarter. So, let's say you bought shares in a company where the shares are $20 each. You invest $1,000 (and pay all fees yourself), so you own 50 shares. The company then pays a dividend of $0.20 each quarter, which means that every three months, the company will pay you $0.20 per share times 50 shares, or $10.

That dividend money is in addition to the normal value of the stock. Naturally, companies that pay a nice dividend tend to have more valuable stock than companies that don't ever pay a dividend (though this isn't an exact rule, of course).

Many large investors own enough stock so that they can live off of dividends. Take that $20 stock. If you had $1,000,000 to invest, you could own 50,000 shares of that stock. Each quarter, if that company pays a $0.20 dividend, you would earn $0.20 per share times 50,000 shares, which adds up to $10,000. You'd essentially earn $40,000 a year just in dividends without ever having to sell any of your stock.

Of course, companies change their dividends regularly. They sometimes cut their dividends — meaning that they're going to pay out a smaller dividend per share this time than they did last time — and sometimes raise them. They also sometimes just leave them alone. Dividends are never a guarantee, but they are a really nice perk, especially with a stable company that has a long history of maintaining and raising dividends.

Usually, the money that's paid to you from dividends is just deposited in your account with your stockbroker, though you can usually instruct the stockbroker to just send that money directly to your checking account.

Reading through a thick mutual fund prospectus can be daunting. AP/Rich Pedroncelli

8. A mutual fund is just a collection of investments, often stocks.

The term "mutual fund" is just what's described above. It's just a collection of investments. Often, a mutual fund is just a collection of various stocks, but it can include other things such as bonds, precious metals, foreign currency, real estate, and other investments. Mutual funds vary in terms of how they're managed as well, with some funds directly managed by teams of people and other funds operated by minimal people either using very simple rules for buying and selling or by using computer algorithms. Mutual funds often come with fees which are usually expressed as an "expense ratio," which tells you how much of the value of the fund is burned up each year to employ the people running the fund (and to earn them a bit of profit).

What exactly a mutual fund invests in and how it is operated is described in a document called a prospectus. I'll be the first to admit that a prospectus can be a daunting (and often boring) read. One way to get a good summary of the information in a prospectus is to visit a site like Morningstar, which compiles this information from tons of different mutual funds.

Most of the time, mutual funds are sold directly by the companies that operate them. If you sign up for an account with the investment firm that manages the specific mutual fund that you're interested in, you can usually buy and sell shares in that mutual fund without any fees at all.

An ETF is a specific kind of mutual fund that's often mentioned. The best way to think of an ETF is as being a mutual fund that itself issues shares which are then bought and sold like any other shares on the stock market. You can buy shares in that ETF from any brokerage. ETFs themselves are often an efficient way to diversify, but you still have to deal with the "buy" and "sell" fees from your brokerage to invest.

9. An index fund is a specific kind of mutual fund, but governed by very simple rules which means the management costs are very low.

Index funds are a very simple type of mutual fund that has very low fees associated with it. Usually, they operate by following a very simple set of rules. For example, an index fund might be governed by a rule that says "buy and hold onto shares in any companies with a value of more than $1 billion." Another one might be to "buy and hold onto shares that are represented in the S&P 500 or the Dow Jones Industrial Average."

Since the rules running index funds are so simple, there's not a whole lot of expense in managing them, so they usually have really low expense ratios. On the other hand, you also don't have people there making specific decisions about changing course if the stock market changes as the index fund just keeps following its rules.

Generally, index funds are a great choice if you're just trying to match the stock market as a whole and have as much diversity as possible. Index funds are all about hitting the average as closely as possible with as few fees as possible.

You won't hit a home run with index funds, but you won't lose money rapidly, either. Brian Kersey/Getty Images

10. My belief is that, for most people, the smartest stock investment is index funds.

If you're unsure what you're doing when it comes to investing money, I have several suggestions to make. First of all, don't invest in stocks (or any other investments) if you have any high interest debt and you should get rid of it first. You should also have a healthy emergency fund. Also, don't invest in stocks if you have any goals that you hope to use that money for in the next ten years because the short-term risk of stocks is pretty significant.

At the same time, I would not suggest investing in the stocks of individual companies unless you can tolerate losing a significant portion of your money and you have a significant amount of time to regularly devote to studying your investments. It is a very risky proposition, particularly when you can't devote a lot of time to constantly following the details of each company that you're investing in.

This essentially leaves you with mutual funds, and among mutual funds, I recommend index funds. Rather than paying high fees to try to beat the market (and often failing, sometimes due to the money eaten by those high fees), I find it's a better approach to put your money into index funds and allow them to just try to match the market with low fees.

You won't hit investment home runs this way, but you won't lose money rapidly either and you won't have to spend all your time researching and studying.

11. Tax-deferred accounts, like your 401(k) at work, are a great option if you're investing for retirement.

Many people look at investing as a way to make sure that they'll have a nice retirement. If that's your goal with investing, you should strongly consider using your 401(k) plan at work (in conjunction with a Roth IRA).

Many employers offer a 401(k) (or 403(b)) plan through their workplace that allows workers to invest their pre-tax income (meaning that you don't have to pay income tax right now on that money) into a special kind of brokerage account, not much different than the ones described above. Within that account, you'll usually have a relatively limited selection of investment options for the money you put in there. Some employers match your contributions which is something you should not miss out on.

When you're retired, you can take money out of that 401(k) as you wish, but you'll have to pay income taxes on everything you pull out. Many 401(k) plans are very helpful when it comes to taxes after withdrawal, so don't worry about it too much.

A Roth IRA is a separate retirement option that doesn't require a plan from your employer. You can open one with almost any investment firm out there, and you put in money from your checking account — it doesn't help you with taxes right now, unlike a 401(k). However, when you withdraw money from a Roth IRA in retirement, you pay no taxes on anything that comes out of the account.

What should you invest in? For retirement accounts, I usually encourage people to choose a "target retirement fund," which is a mutual fund that is made up of investments specifically chosen to offer a great balance of good returns and low risk by the time your retirement date arrives. Just choose the one that most closely matches your expected retirement date and you're good to go!

Don't be frightened off by what you'll owe on your taxes. Tim Boyle/Getty Images

12. Taxes on stocks aren't as scary as they might seem.

Many people worry about taxes when it comes to investing. You shouldn't stress out about them too much.

If you invest in a 401(k), the taxes you'll pay are ordinary income taxes and your brokerage will help. It's essentially taxed like a normal paycheck. If you take money out of a Roth IRA, it's usually tax-free.

What if you're investing for other goals in a normal brokerage account? First of all, you only owe taxes on your gains and your dividends. If you buy into a mutual fund with $10,000 and later sell it for $25,000, you only owe taxes on the $15,000. If you've owned that investment for a while, you'll pay long term capital gains taxes on it — something that's calculated when you file your taxes. Generally, it's much lower than your normal tax rate and for many Americans, it's 0% or 15%. So, you might only owe 15% on the $15,000 you gained, which would be a $2,250 tax. It's pretty easy.

Dividends in a normal account are usually taxed at the lower long term capital gains tax rate — that is, if you've owned the stock for most of the four months prior to a dividend. (If you haven't, it's taxed like normal income.) Dividends in a retirement account just stay in there and you don't have to worry about taxes on them until you take money out of that account.

All you need to know is this: whenever you actually put investment money, whether dividends or money from selling an investment, into your checking account, you should set aside some of it for taxes. I recommend setting aside 20% of it, but you may want to check with a tax professional first.

If you're investing for fun, just make sure that you know what your ultimate goal is. REUTERS/John Schults

So, what should you do?

If you're investing for retirement, use your 401(k) at work and/or a Roth IRA. I generally urge using the 401(k) if your employer offers matching funds; if not, either a 401(k) or a Roth IRA is a good option.

If you're investing just for your own enjoyment, make sure you have your finances in good shape first and know what your goal is when it comes to investing. If your goal is essentially retirement, use retirement accounts if at all possible.

What investments should you choose? I think target retirement funds make sense if you're saving for retirement. If you're investing for something else that comes before retirement, ordinary index funds are best — just choose one based on how much risk you're willing to accept.

If you'd like to know more, my recommended book on investing is "The Bogleheads' Guide to Investing" by Taylor Larimore, Mel Lindauer, and Michael LeBoeuf. That book will sensibly and thoughtfully expand upon all of the topics presented here while still being very readable and enjoyable.